Smoke and Mirrors currently has EBIT of $25,000 and is all-equity financed. EBIT is expected to stay
Question:
Smoke and Mirrors currently has EBIT of $25,000 and is all-equity financed. EBIT is expected to stay at this level indefinitely. The firm pays corporate taxes equal to 21% of taxable income. The discount rate for the firm’s projects is 10%.
a. What is the market value of the firm?
b. Now assume the firm issues $50,000 of debt paying interest of 6% per year, using the proceeds to retire equity. The debt is expected to be permanent. What will happen to the total value of the firm (debt plus equity)?
c. Recompute your answer to part (b) under the following assumptions: The debt issue raises the probability of bankruptcy. The firm has a 30% chance of going bankrupt after 3 years. If it does go bankrupt, it will incur bankruptcy costs of $200,000. The discount rate is 10%.
d. Should the firm issue the debt under these new assumptions?
Discount RateDepending upon the context, the discount rate has two different definitions and usages. First, the discount rate refers to the interest rate charged to the commercial banks and other financial institutions for the loans they take from the Federal...
Step by Step Answer:
Fundamentals of Corporate Finance
ISBN: 978-1260566093
10th edition
Authors: Richard Brealey, Stewart Myers, Alan Marcus